Barbara Trad PHD Candidate

Accounting, Finance, and Economics

QTRS 2019

Effective Business Structures for Australian Small and Medium Enterprises: Is the Trend of Adopting Discretionary Trusts as a Business Structure Counterproductive to the Economy?

Supervisors: Professor Brett FreudenbergDr John Minas Dr Richard Copp

The concept of misuse of trusts throughout history can be found as early as the era of Jerome when he stated in his letter:

Per fidei commissa legibus inludimus (Jerome, Ep. 52.6)

‘by trusts we elude the laws’.Such perceptions could be still valid with the modern-day trusts.

Background Since the 1970s there has been an increasing trend toward the adoption ofdiscretionary trusts as a business structure by small and medium enterprises(SMEs) in Australia (Cooper, 2013).

Australia has a distinctive commercial feature, trusts are significantly used toconduct commercial activities.

The utilisation of trusts is not just restricted to the domain of charitablefoundations and deceased estates.

There were over 800,000 trusts in 2015 (Australian Taxation Office 2018):266,071 (32%) discretionary trusts from trading.335,536 (41%) discretionary trusts from investment.

Expected over 1 million trusts will exist in Australia by 2022 (ATO).

0100,000200,000300,000400,000500,000600,000700,000800,000900,000

1,000,000

Trusts Partnerships Corporations

Lodgement of Tax Returns - Business

Source: Australian Taxation Office (2018). Taxation statistics, 1990–91 to 2014–15.

Background

Issues

Tax neutrality can be breached by tax advantages that are available tocertain SMEs but not to others (Burton, 2006): an entity with a structurethat facilitate income splitting - trusts can benefit from income splittingwhich is not available to sole traders or wage earners.

The issues and concerns are related to the interactions and thecontradictions associated with taxing income depending on itsclassification and on the legal structure of the business.

Differences and applications in the provisions could give rise to a significantcomplexity for businesses.

Open opportunities for taxpayers to manipulate their tax liabilities.

Company Trust

Subdivision204-D

Not permitted to stream dividends

A B

Shareholder Shareholder

207-BSubdivision

Stream dividendsBeneficiaries

Trust CompanyDistributes income

Div. 7A potentially applies

Top marginal tax rate + Medicare

for retaining profit

27.5% or 30%To encourage

company to retain profit

(creating ‘unpaid present entitlement’)

Trustee can accumulate the amount at

corporate tax rate

Research Gap

Holub studied the utilisation of public unit trusts in Australia duringthe 1980s. Freudenberg (2013) explored the important considerations regarding

the formation of businesses. Trad and Freudenberg (2017) explored the factors considered when a

business structure is chosen for a small business. To date there is a paucity of empirical academic research exploring

the reasons why Australian SMEs have been so proactive in utilisingdiscretionary trusts.

Research Questions:

1. What are the reasons for Australian SMEs for the adoption of

discretionary trusts compared to other business structures?

2. What are the implications derived from the adoption of discretionary

trusts by Australian SMEs compared to other business structures?

The Aim of this Research

To determine the reasons behind the utilisation ofdiscretionary trust by Australian SMEs compared toother business structures; and what are thepossible implications of such choice?To investigate whether discretionary trusts providescommercial attributes that are more beneficialthan other business structures.

The Importance of SMEs in Australia

Estimated 2,238,299 SMEs during 2016–2017, representingover 99% of businesses in Australia (ABS 2018).

SMEs account for 67% of employment, and around 57% ofGDP.

Approximately 61% of trading businesses are non-employing,and are generally operated by family members.

Business Structures Used by SMEs

Source: Australian Taxation Office (2018).

Attributes of Discretionary Trusts in the Commercial Arena

1. Asset protection: Property can be protected from the claims of creditors in the event of insolvency.

2. Flexibility in distribution of income: in selection of beneficiaries and the amount distributed to them, in the most tax effective manner, to accommodate to their changing needs.

3. Not a taxable entity: Distributed income retains its pre-tax character as flows through a trust (CGT discount s115-C ITAA97; and franked dividends) – trustee can engineer most tax-effective distribution of business income between beneficiaries.

4. Estate planning: Trust property is not owned by any beneficiary and cannot be passed by a beneficiary’s will. Trust assets, can be passed to the next generation by appropriate consideration of the appointor provisions (in the trust deed).

Issue with Trusts 1. There would be no issue if: (Distributable) Trust income = (Taxable) Net Income

2. Whenever trust income does not include all statutory income (defined by trust deed) – when trust derives capital gains and/or franked dividends Issue

Net income < trust income Result on some of the income not being taxed

Net income > trust income Unfair tax outcome for beneficiaries (tax liability on income not received).

Trust income ≠ Net income Proportionate

approach, Bamford case

Example: Net Income > Trust income

• Net income of trust estate = $100,000• Beneficiaries are presently entitled to

a share of the income of trust estate.• Trustee distributes $80,000 equally to

four beneficiaries.

$80,000

20,000 20,000 20,00020,000

Under the proportionate approach each beneficiaries will be taxed under s97 on $25,000 (25% X 100,000), Even though they only received $20,000 each.

Discretionary Trust as a Vehicle to Avoid Tax

Cost to government: at least $2 billion in lost tax revenue annually (Boccabella, 2017). Multi-million family-run businesses use trust structures to avoid tax -

Aged care sector: exploiting public funding, and compromising thequality of care provided to the elderly and the vulnerable. (Ward,2019).

1 July 2017, Tax Avoidance Taskforce:oMost if not all wealthy groups adopt multiple trusts and companies within their

structures (ATO, 2019).oDiscretionary trusts are the most common structures, trust income accounted

over $340 billion in 2013-14 (ATO, 2019).

The key findings of the commissioned report:The differences in the definitions of income under trust law and tax law are being manipulated and

exploited $1.2 billion to several billions some of used techniques:Distributions < income of the trust - beneficiaries are taxed on their share of the net income of the

trust - at a concessional level or even insolvent. Resulted amounts from the mismatch are distributedto other beneficiaries in the following years, without being taxed.The specific use of loss-making entities, ‘bucket’ companies, or combination of trusts and

companies as beneficiaries. on average 22% were distributed to loss-making company beneficiaries.Complex distributions:Chains of trusts: to create difficulty for ATO to identify the key beneficiaries to assess. Interlinking trusts: whereby at least two trusts make each other presently entitled [Distributions from trust A to trust B

more than doubled over a three-year period: $21 billion (2012) to $50 billion (2015)].

No register of trusts in Australia. Lodgement of trust tax returns is voluntary; no requirements toprovide or maintain constitutive documents of the trusts or other trusts’ relevant information.

Significant issue for international transparency. The lack of information and the difficulty inidentifying the beneficial ownership of trusts; can create an international concern in combatingmoney-laundering, terrorist financing and other threats to the international finance system.

The Treasurer John Howard, announcedreforms to trust to curtail the issue ofincome splitting and to curb the incomedistribution to dependent children.However, under the current rules incomecan still be diverted to other familymembers on a lower/no income.

2017

Treasurer

John Howard

Early 1980s

1985 Late 1990

Treasurer

Paul Keating

Treasurer

Peter Costello

Australian Labour Party

Treasurer Paul Keating, announced that trading trustswould be taxed as companies - This proposal was inresponse to draft White Paper on the reform ofAustralian Taxation System - purpose to curb theavoidance of the two-tiered taxation of companyincome; as the government was concerned about theincrease use of trusts for new ventures instead of usingcompanies.

2017

Treasurer

John Howard

Early 1980s

1985 Late 1990

Treasurer

Paul Keating

Treasurer

Peter Costello

Australian Labour Party

Treasurer Peter Costello proposed to tax family trustslike companies ( A New Tax System). The aim was toachieve a greater consistency in the taxation of entitiesand to reduce compliance and restructuring cost.

2017

Treasurer

John Howard

Early 1980s

1985 Late 1990

Treasurer

Paul Keating

Treasurer

Peter Costello

Australian Labour Party

Recently, the Australian Labour Party announced thatthey will introduce a 30% tax on distributions fromdiscretionary trusts if they win the 2019 federalelection.

2017

Treasurer

John Howard

Early 1980s

1985 Late 1990

Treasurer

Paul Keating

Treasurer

Peter Costello

Australian Labour Party

Simplicity Neutrality Equity

TRUST

Research Methodology

This research project is based on:Scholes and Wolfson’s theory (1992) suggests that the structure choiceis a trade-off between tax and non-tax costs, with firms likely to choosea business structure that minimise these costs.

Research Design

A mixed-method approach of both qualitative and quantitative methods. The combination provides a better understanding of the research issue than either of each method

alone (Creswell, 2017).

Three stages:Stage 1: Pilot Study-Interviews: (10 SME advisors) Foundation for the proposed case studies in stage two. gain understandings of the factors that lead to the choice of business structure.

Stage 2: Case study interviewing SME advisors (40 participants)3 different mock client scenarios (new business). 3 different mock client scenarios (established business).

Stage 3: SME operators (40 participants) In-depth interviews Surveys

Research Methodology

QUESTIONS?